Definitions of Money

Commodity Money
• Commodity money is the simplest and oldest type of money.
• Builds on scarce natural resources that act as a medium of
exchange, store of value, and unit of account.
• Related to (and originates from) a barter system, where goods and
services are directly exchanged for other goods and services
• Facilitates this process because it acts as a generally accepted
medium of exchange.
• Value is defined by the intrinsic value of the commodity itself. In
other words, the commodity itself becomes money
• Examples of commodity money include gold coins, beads, shells,
spices, etc.
Fiat Money
• Fiat money gets its value from a government order (i.e., fiat).
• Government declares fiat money to be legal tender, which requires
all people and firms within the country to accept it as a means of
payment. May be fined or even put in prison.
• Unlike commodity money, fiat money is not backed by any physical
commodity.
• Intrinsic value is significantly lower than its face value. Hence,
the value of fiat money is derived from the relationship
between supply and demand.
• Examples of fiat money include coins and bills followed by most
modern economies
Fiduciary Money
• Fiduciary money relies on the confidence that it will be generally
accepted as a medium of exchange.
• Unlike fiat money, it is not declared legal tender by the
government, which means people are not required by law to
accept it as a means of payment.
• Instead, the issuer of fiduciary money promises to exchange it
back for a commodity or fiat money if requested by the bearer. As
long as people are confident that this promise will not be broken,
they can use fiduciary money just like regular fiat or commodity
money.
• Examples of fiduciary money include cheques, banknotes, or
drafts.
 Commercial Bank Money
• Commercial bank money can be described as claims against financial
institutions that can be used to purchase goods or services.
• Represents the portion of a currency that is made of debt generated by
commercial banks.
• Created through what we call fractional reserve banking (a process where
commercial banks give out loans worth more than the value of the actual
currency they hold).
• Think of it as bank money or debt generated by commercial banks that can
be exchanged for “real” money or to buy goods and services.
• For every $100 received in deposits, banks may only keep $10 behind to
satisfy depositors’ short-term withdrawals, whilst lending out the other $90
• Identify Fiat money & Commercial money??
Money Supply
• Currency and other liquid instruments in a country's economy on
the date measured. The money supply roughly includes both cash
and deposits that can be used almost as easily as cash.
• Governments issue paper currency and coin through some
combination of their central banks and treasuries.
• Bank regulators influence money supply available to the public
through the requirements placed on banks to hold reserves, how
to extend credit and other regulation.

• Go back to macroeconomics: How is money supply defined?

Understanding Money Supply
• Economists analyze the money supply and develop policies
revolving around it through controlling interest rates and
increasing or decreasing the amount of money flowing in the
economy.

• Money supply can affect: price level, inflation, and the business
cycle. In the United States, the Federal Reserve policy is the most
important deciding factor in the money supply. The money supply
(US)is also known as the money stock (UK).
 Effects of Money Supply on the Economy
• An increase in the supply of money typically lowers interest rates, which in
turn, generates more investment and consumption. Businesses respond by ordering
more raw materials and increasing production. The increased business activity raises the
demand for labor.

• Macroeconomic schools of thought focus on role of money supply include: Irving

Fisher's Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory, aka,
Classical & Neoclassical economists

• Measuring money supply shows links between inflation and price levels.
• However, since 2000, these relationships have become unstable, reducing their reliability
as a guide for monetary policy. Although money supply measures are still widely used,
other measures also exist
How Money Supply is Measured
• The various types of money in the money supply are generally
classified as Ms, such as M0, M1, M2 and M3, according to the type
and size of the account in which the instrument is kept. Not all of
the classifications are widely used, and each country may use
different classifications.
• The money supply reflects the different types of liquidity each type
of money has in the economy. It is broken up into different
categories of liquidity or spendability.
• Reserve Money (M0): It is also known as High-Powered Money,
monetary base, base money etc. It is the monetary base of economy.
M0 = Currency in Circulation + Bankers’ Deposits with SBP + Other
deposits with SBP

• Narrow Money (M1):

M1 = Currency with public + Demand deposits with the Banking
system (current account, saving account) + Other deposits with SBP

• M2 = M1 + Savings deposits of post office savings banks

• Broad Money (M3)

M3 = M1 + Time deposits with the banking system
• M4 = M3 + All deposits with post office savings banks
Liquidity of these Measures of Money
Supply
• The liquidity means how fast an instrument can be converted into
cash. The liquidity of these measures are in order M1>M2>M3>M4
i.e. M1 is most liquid and M4 is least liquid.
Money Multiplier
• Relationship b/w monetary base and money supply in economy. The
amount money that banks generates with each unit of money. It is the
ratio of deposits to the reserves in the banking system.

• Money Multilpier=1/Reserve Ratio

• For example let’s say total deposit in banking system is $100 and reserve
ratio requirement is 10%.
The banks can lend 90% of deposit i.e. $90. This $90 that banks will lend
to its customers will ultimately be deposited in another bank which can
further lend 90% of that i.e. $81 and cycle continues.